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Published on: 5/3/2006
Last Visited: 3/27/2008
When a well-known compensation consulting firm predicted in early April that new accounting rules wouldn't have any impact on the use of options as compensation for corporate executives, Wharton accounting professor Mary Ellen Carter was ready to disagree."That's just not true," she says."Options will be cut and directors will be switching to restricted stock for executive compensation."
Carter's response is the result of her research into the role of accounting in the design of CEO equity compensation, specifically as it relates to the use of options and restricted stock.Her study coincides with a ruling, implemented this year by the Financial Accounting Standards Board (FASB), requiring all firms to expense the value of employee stock options.Specifically, Carter looks at the accounting practices of 1,500 firms from 1995 to 2001, before many large companies began expensing stock options but during the years when the FASB began pushing the reform.Carter corroborates the findings of her study by examining changes in CEO compensation within firms that voluntarily began to expense options in 2002 and 2003.
In a new paper on this topic entitled, "The Role of Accounting in the Design of CEO Equity Compensation," Carter concludes that CEO compensation will change now that companies are required to subtract the expense of stock options from their earnings, just as they are required to account for salaries and other costs.And Carter predicts that as a result, firms will switch from options to restricted stock as a preferred compensation option.
"By eliminating the financial reporting benefits of stock options, firms expensing stock options no longer have an ability to avoid recording expenses with any form of equity compensation," writes Carter, who authored the study with Luann J. Lynch, a professor at the Darden Graduate School of Business Administration, and Wharton accounting professor Irem Tuna.
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"Stock options were always seen as an incentive, a way of tying employee or executive action and company performance to compensation," says Carter.
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Noting that "prior literature is inconclusive," Carter set out to determine if favorable accounting for stock options had motivated the use of options, deterred the use of restricted stock, and led to higher overall executive compensation.Carter and her fellow researchers focused on the use of options in CEO compensation before the new accounting standards went into effect -- through either voluntary or required measures.
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To corroborate these findings in her report, Carter also studied 206 firms from the same ExecuComp database that began to expense stock options in 2002 or 2003.Carter's goal was to determine "whether firms that expense stock options alter CEO equity compensation packages in response to the decision to expense options."Based on these firms' experiences, "we examine changes in the structure of CEO pay packages concurrent with and after the decision to expense options," Carter says."Using this sample, we are able to test our hypotheses without having to rely on a proxy for firms' financial reporting concerns.Our findings confirm the role of accounting in equity compensation design.We find that firms expensing options decrease compensation from options and increase compensation from restricted stock, even after controlling for standard economic determinants of compensation and general economic trends."
For instance, Carter found that before expensing options, 88.7% of the firms in this sub-group were granting options as part of a CEO's compensation; during the year the firm first expensed options, the number of firms granting options dropped 18.6%, down to 68.9%; the year after expensing for the first time, the number of firms granting options dropped further to 64.3% for a total decrease of 23.7%.In contrast, the number of firms granting restricted stock to CEOs grew from 42.8% in the year before expensing options to 55% the year after expensing, an increase of 12.2%.
During an interview, Carter pointed to proxy statements from the following two corporations to illustrate how companies shifted from options to restricted stock for CEO compensation:
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Carter found "no evidence of a decrease in total compensation" to CEOs once companies expensed options.The fact that executive pay did not decrease led Carter to one of two conclusions: Either the favorable accounting treatment for stock options did not lead to higher levels of executive compensation "or firms find it difficult to downsize the large executive pay packages that resulted from the favorable accounting treatment for stock options," Carter writes.
In summary, Carter concluded, the fact that "firms are granting fewer options and more restricted stock suggests that these firms are shifting towards restricted stock [in order to] provide longer-term performance incentives, and that there will likely be changes in CEO compensation now that SFAS 123(R) is effective.Though firms may have appeared to favor options, under a regime of mandatory expensing, the role of options in executive compensation may be restricted."
Like an asterisk at the bottom of a key paragraph, Carter and many others who studied the ramifications of options expensing admit that the drop in granting stock options is something of an "unintended consequence" of the new FASB requirement.Why?
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"There really shouldn't be a problem," Carter says.
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